CHAPTER 13
NONDISCRIMINATION AND MINIMUM COVERAGE
REQUIREMENTS FOR PENSION PLANS
Introduction
Qualified pension plans have long been subject to statutory and regulatory requirements designed to ensure that the tax advantages would result
in broad-based coverage of employees—as opposed to plans set up to benefit
only the highly paid employees and/or managers of a firm. Although these
requirements have met with various degrees of success, legislators sought
to accelerate this progress and further broaden employee access to employment-based pension plans through various provisions of the Tax Reform Act
of 1986 (TRA ’86). This chapter deals with two specific criteria that must be
simultaneously satisfied for a plan to have tax-qualified status: nondiscrimination and minimum coverage requirements.
Minimum Coverage Requirements
General Rule—In general, a plan must satisfy one of two requirements
under IRC Sec. 410(b) for those individuals who are employees (or former
employees) on at least one day in each quarter:
Ratio Percentage Test—Under this test, the percentage of the employer’s nonhighly compensated employees (defined in the chapter on ERISA and
pension plans) benefiting under the plan must equal at least 70 percent of
the percentage of the employer’s highly compensated employees benefiting
under the plan. For example, if a plan benefits 60 percent of the employer’s
highly compensated active employees and 35 percent of the employer’s
nonhighly compensated active employees, it fails this test because the plan’s
ratio percentage is less than 70 percent (35 percent/60 percent =
58⅓ percent).
Average Benefit Test—This test has two parts, both of which must be
satisfied. Under the first, the nondiscriminatory classification test, the plan
is required to benefit a classification of employees that does not discriminate
in favor of highly compensated employees. Under the second, the average
benefit percentage test, the average benefit percentage1 of nonhighly com1
The regulations provide detailed guidance concerning the calculation of the individual
benefit percentages that are separately averaged for high-paid and low-paid employees.
Benefit calculations are generally performed using the same actuarial techniques required
by the nondiscrimination rules, with several important simplifications.
Chapter 13: Nondiscrimination and Minimum Coverage Requirements for Pension Plans
129
pensated employees must equal at least 70 percent of the average benefit
percentage of highly compensated employees.
Nondiscriminatory Classification Test—To satisfy the nondiscriminatory classification test under Sec. 410(b), a plan must cover a classification
of employees that is reasonable, reflecting a bona fide business classification
such as salaried and hourly employees. Moreover, the plan must either:
• Benefit at least a safe harbor percentage of nonhighly compensated
employees, or
• Pass a “facts and circumstances” test and benefit at least an unsafe
harbor percentage of nonhighly compensated employees.
Safe Harbor/Unsafe Harbor Tests—Under these tests, the plan’s ratio
percentage must be at least equal to the safe (or unsafe) harbor percentage. Mathematically, this is the same test as the ratio percentage test
explained earlier, but it substitutes the safe (or unsafe) harbor percentage
for 70 percent. The safe (or unsafe) harbor percentages are based on the
concentration percentage2 of all nonhighly compensated employees within
the employer’s work force. Table 13.1 illustrates the safe harbor and unsafe
harbor percentages for specific concentrations of nonhighly compensated
employees. This still leaves a gray area for a plan if it has neither passed the
safe harbor test nor failed the unsafe harbor test. In this case, it may be considered nondiscriminatory based on a review of all facts and circumstances.
Facts and Circumstances Test—The regulations indicate that the following factors, among others, may be considered in applying the facts and
circumstances test:
• The employer’s underlying business reasons for the classification;
• The percentage of the work force that benefits under the plan;
• Whether the number of covered employees in each salary range is representative of the total number of employees in that salary range; and
• How close the classification comes to satisfying the safe harbor
percentage.
Other Factors That Affect Testing
Plans Deemed to Pass—The following plans are deemed to satisfy the
minimum coverage requirements:
• Frozen plans (i.e., plans in which no employees are accruing additional
benefits).
• Plans of an employer that employs only highly compensated employees.
2
The concentration percentage is defined as the ratio of the nonhighly compensated employees to the employer’s total work force (minus any excludable employees), whether or not
they are covered by the plan.
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Fundamentals of Employee Benefit Programs
Table 13.1
Sec. 410(b) Nondiscriminatory Classification Under the
Safe Harbor/Unsafe Harbor Tests
•
•
Concentration
Percentage
Safe Harbor
Ratio Percentage
Unsafe Harbor
Ratio Percentage
60.0% or less
62.0
64.0
66.0
68.0
70.0
72.0
74.0
76.0
78.0
80.0
82.0
84.0
86.0
88.0
90.0
92.0
94.0
96.0
98.0
50.0%
48.5
47.0
45.5
44.0
42.5
41.0
39.5
38.0
36.5
35.0
33.5
32.0
30.5
29.0
27.5
26.0
24.5
23.0
21.5
40.0%
38.5
37.0
35.5
34.0
32.5
31.0
29.5
28.0
26.5
25.0
23.5
22.0
20.5
20.0
20.0
20.0
20.0
20.0
20.0
Plans that benefit only nonhighly compensated employees.
Plans that benefit only union employees (unless more than a de minimis
number of professionals are included).
Excludable Employees—In general, all active and former employees are
taken into account in applying the minimum coverage tests except:
• Employees who have not satisfied the plan’s minimum age and/or service
requirements.
• Collective bargaining unit employees (when testing a noncollective
bargaining unit plan).
• Nonresident aliens with no U.S. source of income.
Compliance—A plan failing to meet the requirements of Sec. 410(b)
as previously described must be brought into retroactive compliance by
the end of the applicable plan year. This may be accomplished either by
Chapter 13: Nondiscrimination and Minimum Coverage Requirements for Pension Plans
131
extending coverage to a broader group of employees or modifying contribution allocations or benefit accruals. However, if the plan fails to meet these
requirements, each HCE must include in income an amount equal to the
employee’s entire vested accrued benefit not previously included in income.
No adverse tax consequences are borne by nonhighly compensated employees (NHCEs) in this case.
Nondiscrimination Requirements
Overview—Sec. 401(a)(4) of the Internal Revenue Code (IRC) provides
that a plan qualifies for favorable tax treatment only if the contributions
or benefits provided under the plan do not discriminate in favor of highly
compensated employees. The regulations for Sec. 401(a)(4) set forth three
requirements a plan must meet to satisfy this condition:
• Either the contributions or the benefits provided under the plan must be
nondiscriminatory in terms of their amount;
• The benefits, rights, and features provided under the plan must be available to employees in the plan in a nondiscriminatory manner; and
• The effect of the plan in certain special circumstances (e.g., plan amendments, grants of past service credit, and plan terminations) must be
nondiscriminatory.
Each of these requirements is explored in more detail in the following
paragraphs.
Nondiscrimination in Amount of Contributions or Benefits—
Although separate rules are provided for determining whether contributions
and benefits are nondiscriminatory, it is generally permissible for a pension
plan to satisfy this requirement by showing that either the contributions or
the benefits are nondiscriminatory. An exception to this general rule applies
to plans subject to Sec. 401(k) or 401(m) and employee stock ownership plans
(ESOPs). (For further discussion, see chapters on 401(k) arrangements and
ESOPs, respectively.) In these cases, the plan must prove that contributions
are nondiscriminatory.
Nondiscrimination in Amount of Contributions—The regulations
for Sec. 401(a)(4) provide two safe harbor tests for defined contribution plans.
The first applies to a defined contribution plan with a uniform allocation
formula that provides employees with uniform allocation rates.3 Permitted
disparity that is explicitly allowed under the allocation formula may be
taken into account in applying this test. The second regulation permits a
defined contribution plan with a uniform allocation formula weighted for
age or service to satisfy the requirement if the average rate of allocation for
3
Treas. Reg. Sec. 1.401(a)(4)-2.
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Fundamentals of Employee Benefit Programs
highly compensated employees under the plan does not exceed the average
rate of allocation for nonhighly compensated employees under the plan.4
If a plan does not satisfy one of these safe harbor tests, it may meet
this requirement by satisfying the general test.5 Under the general test, the
employer contributions allocated under a defined contribution plan are nondiscriminatory in amount for a plan year if each rate group under the plan
satisfies the minimum coverage tests described previously in this chapter. A
rate group exists under a plan for each highly compensated employee (HCE)
and consists of the HCE and all other employees in the plan (both HCEs and
nonhighly compensated employees, or NHCEs) who have an allocation rate
greater than or equal to the HCE’s allocation rate. The allocation rate for an
employee for a plan year equals the sum of the allocations6 to the employee’s
account for the plan year, expressed either as a percentage of plan year
compensation or as a dollar amount. For purposes of determining whether
a rate group satisfies the minimum coverage rules for this test, the rate
group is treated as if it were a separate plan that benefits only the employees included in the rate group for the plan year. The following numerical
example illustrates this concept:7
An employer has six nonexcludable employees, all of whom benefit
under the plan. The HCEs are H1 and H2, and the NHCEs are
N1 through N4. For the plan year, H1 and N1 through N4 have an
allocation rate of 5.0 percent of plan year compensation. For the same
plan year, H2 has an allocation rate of 7.5 percent of plan year compensation. Therefore, there are two rate groups under the plan. Rate
group 1 consists of H1 and all those employees who have an allocation rate greater than or equal to H1’s allocation rate (5.0 percent).
Thus, rate group 1 consists of H1, H2, and N1 through N4. Rate
group 2 consists only of H2 because no other employee has an allocation rate greater than or equal to H2’s allocation rate (7.5 percent).
The ratio percentage (defined previously in this chapter under the
minimum coverage rules) for rate group 2 is zero percent—i.e.,
zero percent (the percentage of all nonhighly compensated nonexclud4
Treas. Reg. Sec. 1.401(a)(4)-3.
5
For the purpose of this calculation, permitted disparity under Sec. 401(l)—i.e., differences
in rates that occur due to integration with Social Security—may generally be taken into account by imputation. (For further discussion, see chapter on integrating pension plans with
Social Security.) However, plans subject to Sec. 401(k) or Sec. 401(m) must satisfy the special
rules provided for them.
6
Allocations of income, expenses, gains, and losses attributable to the balance in an
employee’s account are not taken into account in determining allocation rates.
7
Treas Reg 1.401(a)(4)–2.
Chapter 13: Nondiscrimination and Minimum Coverage Requirements for Pension Plans
133
able employees who are in the rate group) divided by 50 percent (the
percentage of all highly compensated nonexcludable employees who
are in the rate group). Therefore, rate group 2 does not satisfy the
ratio percentage test. Rate group 2 also does not satisfy the nondiscriminatory classification test. Rate group 2 therefore does not satisfy
the minimum coverage rules and, as a result, the plan does not
satisfy the general test. This is true regardless of whether rate group 1
satisfies the minimum coverage tests.
Nondiscrimination in Amount of Benefits—The regulations contain
five safe harbors under which a plan is considered nondiscriminatory with
respect to the amount of benefits. All require that the plan have a uniform
normal retirement benefit, uniform post-normal retirement benefit, uniform
subsidies, no employee contributions, and also that each employee’s benefit
must be accrued over the same years of service that are taken into account
in applying the benefit formula under the plan to that employee.
Those plans that do not satisfy any of the safe harbors must satisfy the
general test for nondiscrimination with respect to the amount of benefits.
The employer-provided benefits under a defined benefit plan are nondiscriminatory in amount for a plan year under the general test if each rate
group under the plan satisfies the minimum coverage tests. For purposes of a
defined benefit plan, a rate group exists under a plan for each HCE and consists of the HCE and all other employees (both HCEs and NHCEs) who have
a normal accrual rate8 greater than or equal to the HCE’s normal accrual
rate, and who also have a most valuable accrual rate9 greater than or equal
to the HCE’s most valuable accrual rate. Thus, an employee is in the rate
group for each HCE who has a normal accrual rate less than or equal to the
employee’s normal accrual rate, and who also has a most valuable accrual
rate less than or equal to the employee’s most valuable accrual rate.
The following example illustrates these rules:10
An employer has 1,100 nonexcludable employees, N1 through N1000,
who are NHCEs, and H1 through H100, who are HCEs. The employer
maintains Plan A, a defined benefit plan that benefits all of these
8
The normal accrual rate for an employee for a plan year is the increase in the employee’s
accrued benefit during the measurement period, divided by the employee’s testing service
during the measurement period, and expressed either as a dollar amount or as a percentage
of the employee’s average annual compensation.
9
The most valuable accrual rate for an employee for a plan year is the increase in the
employee’s most valuable optional form of payment of the accrued benefit during the measurement period, divided by the employee’s testing service during the measurement period,
and expressed either as a dollar amount or as a percentage of the employee’s average annual compensation.
10
Treas. Reg. Sec. 1.401(a)(4)–3.
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Fundamentals of Employee Benefit Programs
nonexcludable employees. The normal and most valuable accrual
rates (determined as a percentage of average annual compensation)
for the employees in the plan for the plan year are listed in the following table.
Employee
N1 through N100
N101 through N500
N501 through N750
N751 through N1000
H1 through H50
H51 through H100
Normal
Accrual Rate
Most Valuable
Accrual Rate
1.0%
1.5
2.0
2.3
1.5
2.0
1.4%
3.0
2.65
2.8
2.0
2.65
There are 100 rate groups in Plan A because there are 100 HCEs in
Plan A. Rate group 1 consists of H1 and all those employees who have
a normal accrual rate greater than or equal to H1’s normal accrual
rate (1.5 percent) and who also have a most valuable accrual rate
greater than or equal to H1’s most valuable accrual rate (2.0 percent).
Thus, rate group 1 consists of H1 through H100 and N101 through
N1000.
Rate group 1 satisfies the ratio percentage test because the ratio
percentage of the rate group is 90 percent, i.e., 90 percent (the percentage of all nonhighly compensated nonexcludable employees who are
in the rate group) divided by 100 percent (the percentage of all highly
compensated nonexcludable employees who are in the rate group).
Because H1 through H50 have the same normal accrual rates and the
same most valuable accrual rates, the rate group with respect to each
of them is identical. Thus, because rate group 1 satisfies the minimum
coverage tests, rate groups 2 through 50 also satisfy the minimum
coverage tests.
Rate group 51 consists of H51 and all those employees who have a
normal accrual rate greater than or equal to H51’s normal accrual
rate (2.0 percent) and who also have a most valuable accrual rate
greater than or equal to H51’s most valuable accrual rate
(2.65 percent). Thus, rate group 51 consists of H51 through H100
and N501 through N1000. (Even though N101 through N500 have
a most valuable accrual rate (3.0 percent) greater than H51’s most
valuable accrual rate (2.65 percent), they are not included in this rate
Chapter 13: Nondiscrimination and Minimum Coverage Requirements for Pension Plans
135
group because their normal accrual rate (1.5 percent) is less than
H51’s normal accrual rate (2.0 percent).)
Rate group 51 satisfies the ratio percentage test because the ratio
percentage of the rate group is 100 percent, i.e., 50 percent (the
percentage of all nonhighly compensated nonexcludable employees
who are in the rate group) divided by 50 percent (the percentage of
all highly compensated nonexcludable employees who are in the rate
group). Because H51 through H100 have the same normal accrual
rates and the same most valuable accrual rates, the rate group with
respect to each of them is identical. Thus, because rate group 51
satisfies the minimum coverage tests, rate groups 52 through 100 also
satisfy the minimum coverage tests. Therefore, the employer-provided
benefits under the plan are nondiscriminatory in amount because
each rate group under the plan satisfies the minimum coverage tests.
Nondiscriminatory Availability of Benefits, Rights, and
Features—Optional forms of benefits, ancillary benefits, and other rights
and features provided under the plan must be nondiscriminatory. Special
rules exist for acquisitions, mergers, and similar transactions. An optional
form of benefit is a distribution alternative that is available under a plan,
an early retirement benefit, or a retirement-type subsidy. Each optional
form of benefit must be currently available and effectively available to a
nondiscriminatory classification of employees. Current availability focuses
on the availability of the option to employees but assumes that certain
conditions such as age or service under the plan’s terms are currently
satisfied. Effective availability examines whether actual availability of the
option, taking into account the ability of employees to satisfy age and service
requirements, substantially favors highly compensated employees.
Ancillary benefits include certain Social Security supplements, disability
benefits, ancillary life insurance and health insurance benefits, death benefits under a defined contribution plan, preretirement death benefits under a
defined benefit plan, and shutdown benefits.
Other rights or features are defined as any right or feature applicable to
employees under the plan, other than a right or feature taken into account
as part of an optional form of benefit or ancillary benefit provided under the
plan and other than a right or feature that cannot reasonably be expected to
be of more than insignificant value to an employee. For example, the following are specifically included in this definition:
• Plan loan provisions.
• The right to direct investments.
• The right to a particular form of investment.
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Fundamentals of Employee Benefit Programs
•
•
•
•
The right to a particular class or type of employer securities.
The right to make a particular rate of before-tax, after-tax, or
matching contribution.
The right to purchase additional retirement or ancillary benefits
under the plan.
The right to make rollover contributions and transfers to and from
the plan.
Bibliography
Cavanaugh, Amy L., and Thomas E. Poje. Coverage and Nondiscrimination
Answer Book. Third edition. Frederick, MD: Aspen Publishers, 2007.
Fuller, David R., and Susan M. Nash. Employer’s Handbook: Complying With
IRS Employee Benefits Rules. Washington, DC: Thompson Publishing
Group, ©1988-2008 (updated monthly).
Great-Western Retirement Services. 401(k) Answer Book. New York: Aspen
Publishers, 2008.
Patterson, Martha Priddy, Joseph S. Hessenthaler, and Paul M. Hamburger.
The 401(k) Handbook. Washington, DC: Thompson Publishing Group,
©1991–2008 (updated monthly).
Additional Information
American Academy of Actuaries
1100 Seventeenth Street, NW
Washington, DC 20036
(202) 223-8196
www.actuary.org/index.asp
International Foundation of Employee Benefit Plans
18700 W. Bluemound Road
Brookfield, WI 53045
(262) 786-6710
www.ifebp.org
Chapter 13: Nondiscrimination and Minimum Coverage Requirements for Pension Plans
137